How MF Global’s ‘missing’ $1.5 billion was lost — and found

Former New Jersey governor Jon Corzine was CEO of MF Global when it filed for bankruptcy in 2011.

FORTUNE — Scandal junkies may have been puzzled last week when they learned that the 26,000 customers of Jon Corzine’s MF Global, the infamous commodities firm that flamed out two years ago, leaving behind an unprecedented $1.5 billion shortfall in supposedly sacrosanct customer accounts, will likely now be receiving a stunning 100 cents back on every dollar of their principal.

The accomplishment is an unambiguous coup for special trustee James W. Giddens, of New York law firm Hughes Hubbard & Reed, who took charge of the smoldering wreckage on Halloween Day 2011. Giddens had never been expected to work such a miracle. But does the surprising asset recovery require a rewrite of the tale of alleged villainy that ushered Giddens onto the scene in the first place?

The recovery — approved by U.S. Bankruptcy Judge Martin Glenn last week, though it might yet be appealed — “likely demonstrates that the segregated money never really was missing,” says Corzine spokesperson Steven Goldberg of RLM Finsbury, “nor was it misused as part of some conspiracy or intentional wrongdoing, as has long been insinuated.”

So where, exactly, was the $1.5 billion all this time?

Corzine’s argument, as articulated by Goldberg, runs as follows: “As Mr. Corzine testified before Congress nearly two years ago, he has long believed that the majority of the so-called missing customer money was in the possession of certain financial institutions that held onto it to protect their own interests … In addition, $700 million of the [total] that was supposedly missing was secured customer money that was held up in the U.K. due to British bankruptcy laws.”

Corzine and seven other individuals who have been sued civilly in 12 consolidated class actions brought by the MF Global customers have said, through their attorneys, that they will move to dismiss those cases once the trustee’s final distribution is approved, arguing that the plaintiffs’ claims will have then been “extinguished” by the trustee’s success.

Trustee Giddens — who was also the court-appointed trustee in charge of liquidating Lehman Brothers — will certainly oppose those motions, however. He, for one, does not share Corzine’s belief that recovery of the shortfall implies exoneration of Corzine or any other MF Global officer and director. “The reduction [in the customer account shortfall] that resulted from the Trustee’s efforts should not obscure the fact,” wrote one of Giddens’s staffers in a court filing last month, “that a very real shortfall in the amount of $1.5 billion existed at the time the Trustee began the liquidation process, and it was mainly through litigation and negotiation with affiliates and other third parties that the gap has been reduced.”

Last week another attorney working with Giddens stressed in an updated court submission that at least $560 million would still be missing from those customer accounts to this day were it not for the fact that Giddens has plugged that void with “advances” from the general estate, moneys that would otherwise have been available for paying general creditors, such as vendors, suppliers, and service-providers. The last of these was the $233 million injection just approved on Nov. 6 by Bankruptcy Judge Glenn. (The total amount advanced, however, is expected to shrink to somewhere between $435 million and $460 million after one additional expected transfer from the U.K. lands in the kitty in the coming months.)

These advances, in turn, were conditioned on a deal — whose legality is hotly contested by Corzine and his co-defendants — that allows trustee Giddens to step into the shoes of the class-action customer claimants and continue litigating their claims against the individual defendants. (The case would actually still be litigated by the class-action attorneys who brought it, though Giddens, as trustee for the general creditors, would now be the beneficiary.)

Giddens is also not backing away from any of the fundamental findings of a 275-page investigative report he issued in June 2012. There he found that there was a basis for asserting “breach of fiduciary duty and negligence” claims against Corzine and other officers, charges that have in fact been leveled against Corzine in the class actions as well as in an enforcement action filed by the U.S. Commodity Futures Trading Commission this past June.

Finally, argues Kent Jarrell, a spokesperson for Giddens, the defendants’ failure to adequately safeguard customer funds has deprived the company’s commodities customers of access to their money for more than two years without any certainty of ever seeing it again, and with no interest to show for their pains.

Still, there are at least elements of Corzine’s position that ring true — particularly with respect to the moneys trapped in England.

So, basically, it’s complicated. But we’ll try to untangle it for you by answering five key questions prompted by the recent news.

What was the series of events that allowed $1.5 billion to go “missing” in the first place?

In March 2010, Corzine — the then former Goldman Sachs GS chief, former U.S. Senator, and former New Jersey governor — shocked observers from Main Street to Wall Street when he took the reins at MF Global, a low-profile, financially struggling commodities broker. At the time, the firm traded pork bellies for farmers and currencies for hedge funds, as my colleague Peter Elkind explained in a magisterial feature story in June 2012 and in an update this past July. The firm Corzine inherited made its money from interest on customer deposits and commissions on trades.

Corzine abruptly yanked the firm in a different direction, trying to morph it into a Wall Street investment bank that made money off risky, proprietary trading. The company’s biggest bet, overseen by Corzine himself, was a multi-billion position in European sovereign debt, especially the bonds of Italy, Spain, Portugal, and Ireland.

According to Giddens, this wrenching change in direction for the firm was never accompanied by the sort of modernization of its computer systems and back-office infrastructure that he believes was required. Thus, he noted in his June 2012 report, after Corzine’s arrival the firm often continued to track and record transactions and liquidity “by informal means that were derived from a number of different reports, both computerized and oral.”

By the summer of 2011, with fears of Eurozone country defaults forcing the company to post ever-larger margins on its proprietary accounts, the company entered a liquidity crisis. Matters deteriorated further when, in late October, 2011, the company announced disastrous quarterly results — a $191 million loss. Its credit ratings were downgraded, triggering a run on the bank. On Oct. 31, 2011, MF Global’s holding company filed for Chapter 11 bankruptcy, and Giddens, nominated by the Securities Investor Protection Corporation, was appointed by U.S. District Judge Paul Engelmayer to seize and liquidate the company’s commodities and securities brokerage unit.

It was immediately apparent to Giddens that the laws and regulations designed to ensure that customer accounts are kept segregated and inviolate had been breached, that some customer funds had been used to “support proprietary transactions,” as he wrote in June 2012, and that, as a consequence, there was a “significant shortfall” in funds available to satisfy customer claims. When the dust cleared he first estimated that deficiency at $1.6 billion, though with more information available today he has recently tweaked the figure down to $1.5 billion.

Giddens determined that the first unambiguous breach of segregation rules occurred on Oct. 26, 2011, five days before the company filed for bankruptcy. (The CFTC has subsequently calculated that the deficiency at the end of business on that day was $298 million.)

Though MF Global was required to immediately notify the CFTC of an “under-segregation” violation of this sort, it did not do so. The impermissible transfers continued until, by the morning of Oct. 31, customer accounts had been raided to the tune of more than $900 million. These transgressions were part of a blizzard of ricocheting intra-company transfers and outgoing payments that occurred as the company desperately tried to stave off bankruptcy. “MF Global’s computer systems and employees had difficulty keeping up with the unprecedented volume of transactions,” Giddens wrote in his June 2012 report. “Some transactions were recorded erroneously or not at all,” he continued, a factor that contributed to Giddens’ challenge in reconstructing what occurred.

At the eye of this storm, in the company’s back offices in Chicago, was assistant treasurer Edith O’Brien, who is the only MF Global official besides Corzine to be named as a defendant in the CFTC enforcement action. (The CFTC alleges that she “directed, approved, and/or caused numerous illegal transfers of customer segregated funds to the Firm’s proprietary accounts.”) O’Brien has denied wrongdoing.

Where did the money come from to pay back the $1.5 billion shortfall?

We’ll provide a rough breakout, but remember that a shortfall is the difference between assets on hand and outstanding claims. So a shortfall can be narrowed in two ways: either by getting an influx of cash, or by receiving a release (or set-off) of claims.

Keeping that in mind, the key developments were these: About $725 million of money (of which about $460 million was cash and the rest was released claims) has been received so far from a settlement involving MF Global customer accounts that were located in the U.K. in order to enable those customers to trade on foreign exchanges. (These are part of what Corzine’s spokesperson was referring to as “shortfall” moneys which were never really missing in the first place.) After the arrival of a final tranche of between $102 million and $123 million in cash from those U.K. accounts sometime in the coming months, the total amount of the retired shortfall from that source (including released claims) is expected to reach between $830 million and $850 million.

Another $130 million in cash came from JP Morgan Chase JPM, representing funds that the bank came to agree were customer funds, though the bank initially considered them, due to allegedly poor documentation by MF Global, as MF Global’s proprietary funds — subject to possible setoff by claims the bank had against MF Global.

Close to $170 million in shortfall reduction (of which about $60 million was in cash) resulted from a settlement with MF Global’s Canadian unit, where customer accounts were marooned (though much more briefly) for reasons analogous to those afflicting the U.K. accounts.

The remaining shortfall reduction consists of the $560 million in advances mentioned earlier, which come from the funds available to MF Global’s general creditors. (When the moneys from the U.K. arrive, the outstanding advances will be reduced to $435 million to $460 million.)

But these advances are controversial. One reason the general estate had these funds available to “advance” to customers in the first place is that trustee Giddens reached settlements on the general estate’s behalf with financial institutions — like, again, JP Morgan — which were returning funds and collateral that purportedly related to MF Global’s proprietary business. But Corzine and the other individual defendants — whom Giddens hopes to hold responsible for paying back these advances — contend that some of these funds were, in reality, customer funds to begin with and, therefore, should never have gone to the general estate.

Corzine says the banks dragged their feet in returning customer funds. If so, the delay isn’t Corzine’s fault. Is he right?

An important settlement with JP Morgan Chase — the one from which $100 million in cash went directly to the customers and from which another $200 million eventually reached them indirectly, in the form of “advances” from the general estate — was not inked until March of this year, and not approved by the court till July.

Giddens denies, however, that this settlement involved any properly segregated client funds. To understand Giddens’s argument, we need to step back.

It’s true that when the music stopped on Halloween 2011, properly segregated customer funds were dispersed in the custody of a large number financial institutions, exchanges, clearinghouses, and other third parties in the form of investments and margin accounts and other perfectly permissible uses. One of the trustee’s first tasks was to recover those moneys.

And that is what Giddens did. But the banks, according to Giddens spokesman Jarrell, were “quite cooperative” when it came to returning properly segregated customer accounts. JP Morgan, for instance, returned more than $1 billion in such funds within weeks of Giddens’s appointment, as did BMO Harris Bank. Accordingly, such funds were never counted as composing any part of the $1.5 billion shortfall, according to Jarrell.

The bank funds that took longer to retrieve, Jarrell contends, were different. These were the funds the banks received during, for the most part, that wild final week of October 2011, when money was being wired all over the place willy-nilly. The origins of those transfers were hard to trace for everyone concerned. Many of MF Global’s banks handled its proprietary transactions as well as customer transactions.

Seeking to protect their own legitimate interests vis-à-vis their other lines of business, Jarrell contends, the banks were predictably slower to return money transferred to them that hadn’t been characterized as customer funds at the time of the transfer. Hashing out the competing claims to those moneys took time, Jarrell says.

What about the more than $700 million in customer funds trapped in England? Corzine says this cash was “secured customer money that was held up in the U.K. due to British bankruptcy laws.” If so, that money wasn’t really ever “missing,” was it?

Here Corzine is on more solid ground. There appears to be no dispute that U.K. receivership laws are less protective of customer funds than U.S. law. In January 2012, Giddens asked the English receivers administering MF Global’s English subsidiary, MFGUK, to return the money in customer accounts that Giddens argued had been adequately secured and labeled under English law. The English receivers, however, determined that the money had to be treated as general estate property under English law.

Giddens and the English receivers — known as joint special administrators — then each dug in their heels for a period and looked to be on track for a lengthy, multi-year litigation over this money. They worked out a settlement last Christmas, which was clearly the most important breakthrough for full recovery of the shortfall. When the last moneys from England are received Giddens will have recovered at least $830 million of the shortfall (including close to $600 million in cash) from that one settlement.

So to the extent an unanticipated interpretation of British law interfered with the return of properly secured funds in England, Corzine has a point. While those moneys were unavailable to the Trustee to satisfy customer claims — which is why he counted them as part of the “shortfall” — they weren’t exactly “missing,” as reporters have tended to describe them.

But Jarrell, the spokesman for Giddens, says it’s not so simple. The international litigation that was averted by last Christmas’s settlement, he contends, was not simply over disputed legal principles, but also over knotty factual disputes, which he does not detail. He suggests that if MF Global had dotted its i’s and crossed its t’s more diligently and prudently, the entire quagmire may have been averted. In fairness to Corzine, though, Giddens in his June 2012 report — whether as a matter of legal strategy or otherwise — never laid out whatever qualms he now says he had with MFGUK’s conduct in this regard, nor has he ever laid them out subsequently.

If there’s a hard and fast rule about not using customer funds for proprietary purposes, and there’s no dispute that at least $900 million in customer funds did somehow get used for proprietary purposes, why isn’t anybody going to jail?

There are three intertwined factors that answer that question. First, segregating customer funds is easier said than done. Second, MF Global appears to have had very bad record-keeping systems, which certainly can warrant a charge of negligence, but isn’t a crime in itself. Third, there was a weird rule in place at the time of these events which, though it doesn’t let anybody off the hook, did play at least a bit part in exacerbating the damage from what occurred. (Giddens’ number-one recommendation in his June 2012 report was abolishing that CFTC rule, and in a rule-making procedure completed just last month, the CFTC did just that.)

To understand the interaction of these three factors, a little background is necessary. There were two categories of commodity customer at MF Global, each covered by slightly different CFTC rules. Those trading on domestic exchanges were protected by laws and regulations that very clearly required the broker to maintain segregated customer accounts and to perform certain daily calculations to ensure that sufficient moneys would always be available on hand to liquidate fully each account if needed. That calculation was known as the Net Liquidating Value formula.

Those trading on foreign exchanges, on the other hand, were covered by a different CFTC regulation — the one that Giddens faulted. We’ll get to that in a moment.

But even with respect to those customers trading on domestic exchanges, subject to clear-cut rules, there was a complicating factor. Funds in customer accounts are always fluctuating, depending on how their volatile commodities positions are faring in the market. If their positions go up in value, the commodities broker has to pony up more money to make sure the Net Liquidation Value of that account remains fully covered.

To cover these daily fluctuations, commodities brokers often add their own money to customer-segregated accounts to create a “cushion.” This cushion, known at MF Global as “excess seg,” could lawfully be withdrawn at any time for proprietary purposes, since those funds were proprietary funds to start with. But if a company’s recordkeeping is sloppy — as MF Global’s allegedly was — an officer might mistakenly withdraw more than the actual “cushion” from a customer account, breaching the segregation rule.

Now let’s turn to the customers trading on foreign exchanges. They were covered by a different CFTC regulation known as 30.7. Strangely, this rule gave brokers a choice of methodologies for computing how much money they needed to keep on hand to safeguard customer accounts in the event of an emergency. They could, if they chose, use the same Net Liquidation Value computation that they were required to use to safeguard customers trading on domestic exchanges. But for reasons that are beyond the scope of this article, they could also choose to use a different formula, known as the Alternative Method. The Alternative Method formula generated a much lower sum — one that was, frankly, inadequate in the event liquidation became necessary. That might sound crazy, but that’s how things stood.

MF Global’s policy was, for its foreign exchange customers, to compute both the Net Liquidation Value — the amount that would really be needed to safeguard customers in the event of an emergency — and the lower Alternative Method figure. The gap between the two was referred to in-house as the “regulatory excess.” By October 2011, the aggregate “regulatory excess” for all foreign exchange customers was more than $1 billion, according to Giddens.

Naturally, when MF Global began to feel the bite of the liquidity crunch in the summer of 2011, its officials inquired into whether they could dip into the regulatory excess to find cash to prop up the proprietary end of their business. The answer was that while doing so would have been legal — and the CFTC appears to concede in its enforcement complaint that it would have been — that as a matter of firm policy the company would adopt a more conservative rule. They would allow dipping into the “regulatory excess” in the foreign exchange accounts only to the extent that there was an equal amount of “excess seg” on hand for the domestic exchange accounts to make up for it.

With that, the stage was set for the final, smooth slide into oblivion. Piecing together the findings of Giddens’s June 2012 report and the allegations of the CFTC’s June 2013 enforcement complaint, the final descent went like this.

In mid-October the company started regularly breaching its firm-wide segregation policy (dipping into the “regulatory excess” even when there wasn’t enough “excess-seg” to cover it), but it was not yet breaching the actual CFTC segregation rules. On Oct. 26, however, it finally broke the actual CFTC segregation rules, though the MF Global officers whom the CFTC alleges knew about it — O’Brien and, perhaps, a few others — hoped to confine the breach to an intraday phenomenon that could be set right by the end of the business day.

When the money wasn’t returned in time, they allegedly tried to fix the “seg problem” before the regulatory segregation report had to be filed the next day by noon. They couldn’t. Then, to make matters worse, poor recordkeeping made the extent of the breach seem less grave to the MF Global officers involved than they really were — at least at first. In any event, for whatever reason nobody told the CFTC and, five days later, close to a $1 billion of customer money had flown out the door. It took two years for Giddens to get it back.

There’s not necessarily any criminal conduct involved in that scenario. On the other hand, is it a no-harm-no-foul situation? I don’t think so.